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FINANCIAL MANAGEMENT
THEORY & PRACTICE
ADAPTED FOR THE SECOND CANADIAN
EDITION BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
CHAPTER 22
INTERNATIONAL FINANCIAL
MANAGEMENT
CHAPTER 22 OUTLINE
• Multinational, or Global, Corporations
• Multinational vs. Domestic Financial
Management
• Exchange Rates
• Exchange Rates and International Trade
• The International Monetary System and
Exchange Rate Policies
• Trading in Foreign Exchange
• Interest Rate Parity
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22-3
CHAPTER 22 OUTLINE (cont’d)
•
•
•
•
•
•
Purchasing Power Parity
Inflation, Interest Rates, and Exchange Rates
International Money and Capital Markets
Multinational Capital Budgeting
International Capital Structures
Multinational Working Capital Management
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22-4
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22-5
Multinational, or Global, Corporations
• A corporation registered in one country but
with integrated operations in two or more
countries
• At one time, most multinationals produced
and sold in just a few countries.
• Today, many multinationals have world-wide
production and sales.
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Companies “Go Global”
• Why do firms expand into other countries?
– To seek new markets
– To seek new supplies of raw materials
– To gain new technologies
– To gain production efficiencies
– To avoid political and regulatory obstacles
– To reduce risk by diversification
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22-7
Multinational vs. Domestic Financial
Management
•
•
•
•
•
•
Currency differences
Economic and legal differences
Language differences
Cultural differences
Government roles
Political risk
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Exchange Rates
As of
Cdn. $ required
12/31/2012
to buy 1 Unit
Euro
1.3088
Swiss franc
Unit Number
for one Cdn.$
0.7641
1.0833
0.9231
• The exchange rate is the price of one country’s
currency for another’s.
• Currency prices have direct or indirect
quotations.
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Direct vs. Indirect Quotation
• Values of foreign currencies shown in Cdn. dollars are
direct quotations: a dollar sign in these quotations
stating the number of dollars per currency (i.e., $/₤)
• An indirect quotation gives the amount of a foreign
currency required to buy one Cdn. dollar (i.e., ₤/$).
• Note that an indirect quotation is the reciprocal of a
direct quotation.
• Euros and British pounds are normally quoted as direct
quotations. All other currencies are quoted as indirect.
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Calculate the Indirect Quotations for
Euros and Swiss Francs
• Euro:
• Swiss franc:
1 / 1.3088 = 0.7641
1 / 1.0833 = 0.9231
Indirect Quotes: #
Direct Quote: Cdn. of Units of Foreign
$ per foreign
Currency per Cdn.
currency
$
Euro
Swiss franc
1.3088
1.0833
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0.7641
0.9231
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What is a Cross Rate?
• A cross rate is the exchange rate between any
two currencies not involving Cdn. dollars.
• In practice, cross rates are usually calculated
from direct or indirect rates; that is, on the
basis of Cdn. dollar exchange rates.
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Cross Rates Between Euros
and Swiss Franc
Cross Rate = Euros × Dollars
Dollar
Swiss franc
= 0.7641 x 1.0833
= 0.8277 euros/Swiss franc
Cross Rate =Swiss franc × Dollars
Dollar
Euros
= 0.9231 x 1.3088
= 1.2082 Swiss francs/euro
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Note: Cross Rates
• The two cross rates are reciprocals of one
another.
• They can be calculated by dividing either the
direct or indirect quotations.
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Exchange Rates and
International Trade
• Artificially holding down the value of a
currency stimulates exports but at the
expense of potentially overheating and
inflating the economy.
• A currency that is artificially high has the
opposites: inflation will be held down, people
can purchase imported goods at low domestic
prices, but exporting industries are hurt.
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Example of
International Trade Transactions
• Assume a firm can produce a litre of orange
juice in Canada and ship it to Spain for $1.75.
If the firm wants a 50% markup on the
product, what should the juice sell for in
Spain?
Target price = ($1.75)(1.50)= $2.625
Spanish price @ $1.3088/€
= ($2.625)/($1.3088) = € 2.01
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The International Monetary System
and Exchange Rate Policies
From 1946-1971:
• Prior to 1971, a fixed exchange rate system was in
effect.
• The US dollar was tied to gold.
• Other currencies (including Cdn. dollar) were tied
to the US dollar at fixed exchange rates (and
indirectly linked to gold).
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The International Monetary System:
1946-71 (cont’d)
• Central banks intervened by purchasing and
selling currency to even out demand so that
the fixed exchange rates were maintained.
• Occasionally the official exchange rate for a
country would be changed.
• Economic difficulties from maintaining fixed
exchange rates led to its end.
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The Current International
Monetary System
• The current system for most industrialized
nations is a floating rate system where exchange
rates fluctuate due to changes in demand.
• Currency demand is due primarily to:
– trade deficit or surplus
– capital movements to capture higher interest rates
• Exchange rate fluctuations can have a profound
effect on businesses.
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Freely, or Independently, Floating Rates:
Currency Appreciation/Depreciation
• Suppose the exchange rate freely goes from
103.5 yen/dollar to 105.0 yen/dollar.
• A dollar now buys more Japanese yen, so the
dollar is appreciating, or strengthening.
• Yen is depreciating (or weakening).
• A strengthening dollar hurts exports.
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Floating System: Exchange Rate Risk
• The inherent volatility of the floating exchange
rate system increases the uncertainty for the
firms.
• Exchange rate risk is the risk that the value of
a cash flow in one currency translated from
another currency will decline due to a change
in exchange rates.
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Managed Floating Rates
• There is significant government intervention
to manage the exchange
rate by manipulating the currency’s
supply and demand.
• Government rarely reveals its target exchange
rate levels if it uses a
managed-float regime to avoid
currency speculation.
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Pegged Exchange Rates
• Many countries still use a fixed exchange rate
that is “pegged,” or fixed, with respect to
another currency or basket of currencies.
• Examples of pegged currencies:
– Chinese yuan
– Chad uses CFA franc, pegged to French franc,
which is pegged to the euro.
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Currency Devaluation/Revaluation
• Under a pegged exchange rate system, the
government sets up and maintains a target
fixed exchange rate.
• When the government lowers the target rate,
this is called devaluation.
• When the target rate is increased, it is called
revaluation.
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Convertible Currency
• A currency is convertible when the issuing
country promises to redeem the currency at
current market rates. Known as “hard’
currency.
• Convertible currencies are freely traded in
world currency markets.
• Residents and nonresidents are allowed to
freely convert the currency into other
currencies at market rates.
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Problems Due to Nonconvertible
Currency
• It becomes very difficult for multinational
companies to conduct business or to invest
directly because there is no easy way to take
profits out of the country.
• Often, firms will barter for goods to export to
their home countries.
• Lack of convertibility significantly inhibits the
ability of a country to attract foreign
investment.
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Nonconvertible Currency
• When there are restrictions on convertibility, a
black market will often arise.
• Examples of nonconvertible currencies (a.k.a.
soft currencies):
– Chinese yuan
– Venezuelan bolivar
– Uzbekistan sum
– Vietnamese dong
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No Local Currency
• Countries do not have their own separate
legal tender but instead use the currency of
another nation.
• Examples: Ecuador has used the USD since
September 2000, and the 17 EMU members
have used the euro since 2002. The euro
replaced their domestic currencies.
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22-28
Trading in Foreign Exchange
• Foreign exchange market is the world’s largest
financial market where one country’s currency
is traded for another’s.
• Most of the trading takes place in a few
currencies: US dollars ($), euro (€), British
pound sterling (₤), Japanese yen (¥), and Swiss
franc (SF).
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22-29
Spot Rates and Forward Rates
• A spot rate is the rate applied to trade
currency for immediate delivery (“on the
spot”).
• A forward rate is the rate applied to buy
currency at some agreed-upon future date
(usually 30, 90, or 180 days).
• Forward rates are normally reported as
indirect quotations.
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22-30
When is the Forward Rate at a
Premium to the Spot Rate?
• If the Cdn. dollar buys fewer units of a foreign currency
in the forward than in the spot market, the foreign
currency is selling at a premium.
• For example, suppose the spot rate is 0.7 £/$ and the
forward rate is 0.6 £/$.
• The dollar is expected to depreciate because it will buy
fewer pounds.
• The pound is expected to appreciate since it will buy
more dollars in the future.
• So the forward rate for the pound is at a premium.
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22-31
When is the Forward Rate at a
Discount to the Spot Rate?
• If the Cdn. dollar buys more units of a foreign
currency in the forward than in the spot
market, the foreign currency is selling at a
discount.
• The primary determinant of the spot/forward
rate relationship is the relationship between
domestic and foreign interest rates.
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22-32
Spot and Forward Rates (Indirect
Quotation)
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Interest Rate Parity
Interest rate parity (IRP) implies that investors
should expect to earn the same return on
similar-risk securities in all countries:
Forward rate = 1 + rh
1 + rf
Spot rate
Forward and spot rates are direct quotations.
rh = periodic interest rate in the home country
rf = periodic interest rate in the foreign country
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Interest Rate Parity: Example
• Assume 1SF = $0.81 in the 90-day forward
market. 90-day Canadian T-bills have a 1.125%
interest rate, whereas a 1.25% in Switzerland.
Does interest rate parity hold?
• Spot rate: 1$ = 1.2SF or 1SF = $0.8333
rh = 1.125%(4) = 4.5%
rf = 1.25% (4) = 5.0%
(More...)
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Interest Rate Parity: Example (cont’d)
1 + rh
Forward rate
= 1+r
Spot rate
f
Forward rate 1.045
= 1.050
0.8333
Forward rate = 0.8294
If interest rate parity holds, the implied
forward rate, 0.8294, would equal the
observed forward rate, 0.8100; so parity
doesn’t hold.
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22-36
Purchasing Power Parity
Purchasing power parity (PPP) (law of one
price) implies that the level of exchange rates
adjusts so that identical goods cost the same
amount in different countries.
Ph = Pf(Spot rate),
or
Spot rate = Ph/Pf
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PPP: Example
• Cdn. grapefruit juice is $2.00/litre. If
purchasing power parity holds, what is the
price in Spain?
• Spot rate = Ph/Pf.
$0.8000 = $2.00/Pf
Pf = $2.00/$0.8000 = 2.5 euros
• Do PPP and IRP hold exactly at any point in
time?
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Inflation, Interest Rates, and
Exchange Rates
• Relative inflation rates influence relative
interest rates and exchange rates.
• A foreign currency will depreciate or
appreciate at a percentage rate approximately
equal to the amount by which its inflation rate
exceeds or is less than the other country’s
rate.
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Relative Purchasing Power Parity
• Interest rate in a country is largely determined
by its inflation rate.
• Relative PPP refers to the effect that differing
inflation rates has on the change in exchange
rates.
Expected
spot rate
=
(1 + ih) × Spot rate
(1 + if)
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Interest Rates and Exchange Rates:
International Financing Issues
• Lower inflation leads to lower interest rates,
so borrowing in low-interest countries may
appear attractive to multinational firms.
• However, currencies in low-inflation countries
tend to appreciate against those in highinflation rate countries, so the true interest
cost increases over the life of the loan.
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International Money and Capital
Markets
• Eurocurrency markets
– Dollars held outside Canada (i.e. Euro-Canadian)
– Mostly Europe, but also elsewhere
• International bonds
– Foreign bonds: Sold by foreign borrower but
denominated in the currency of the country
where bonds are sold.
– Eurobonds: Sold in country but denominated in
the currency some of other country
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International Stock Markets
• Multinational corporations sell new issues of
stock simultaneously in stock markets in many
countries.
• In addition to new issues, outstanding stocks
of multinationals are increasingly being listed
in multiple international exchanges (for
example, American Depository Receipts
(ADRs) in the United States).
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Multinational Capital Budgeting
• Foreign operations are taxed locally, and then
funds repatriated may be subject to Canadian
taxes.
• Foreign projects are subject to political risk.
• Funds repatriated must be converted to
Canadian dollars, so exchange rate risk must
be taken into account.
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22-44
Foreign Project Analysis
• Project future expected cash flows,
denominated in foreign currency.
• Use the interest rate parity relationship to
forecast expected exchange rates and convert
the future expected foreign cash flows into
dollars.
• Discount the dollar denominated cash flows at
the risk-adjusted cost of capital for similar
Cdn. projects.
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Capital Budgeting: Example
• A Canadian company invests in a project in
Japan.
• Expected future cash flows:
– CF0 = - ¥1,000 million
– CF1 = ¥500 million
– CF2 = ¥800 million
• Risk-adjusted cost of capital in Canadian funds
= 10%
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Interest Rate and Exchange Rate Data
• Current spot exchange rate = 110 ¥/$ using
indirect quotation
• Cdn. government bond rates:
– 1-year bond = 2.0%
– 2-year bond = 2.8%
• Japan government bond rates:
– 1-year bond = 0.05%
– 2-year bond = 0.26%
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Forecast Expected Future Exchange
Rates
Multi-year interest rate parity relationship:
Forward rate = 1 + rh
1 + rf
Spot rate
t
Forward and spot rates are direct quotations.
rh = annual interest rate in the home country
rf = annual interest rate in the foreign country
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Expected Future Exchange Rates (cont’d)
• Direct spot rate = (1/110 ¥/$) = 0.009091 $/¥
• 1-Year expected forward rate:
= (spot rate)[(1 + rh)/(1 + rf)]1
= (0.009091)[(1 + 0.02)/(1 + 0.0005)]
= 0.009268
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Expected Future Exchange Rates (cont’d)
• 2-Year expected forward rate:
= (spot rate)[(1 + rh)/(1 + rf)]2
= (0.009091)[(1 + 0.028)/(1 + 0.0026)]2
= 0.009557
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Project Cash Flows
0
Cash flows
in yen
Expected
exchange
rates
Cash flows
in dollars
1
2
-¥1,000
¥500
¥800
0.009091
0.009268
0.009557
-$9.09
$4.63
$7.65
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Project NPV
NPV = -$9.09
+
$4.63
(1 + 0.10)
+
$7.65
(1 + 0.10)2
NPV = $1.44 million
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International Capital Structures
• Worldwide capital structure should not be
piecemeal decisions; worldwide issues need
to be considered in order to maximize firm
value.
• Implicit or explicit guarantees of subsidiary
debt by the parent firm make the parent’s
overall capital structure the primary concern.
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22-53
International Capital Structures (cont’d)
• The MNC’s object is to raise funds in the most
cost-effective manner at the subsidiary level
and then make adjustments at the firm level.
• Because of exchange controls and tax effects,
MNCs often use debt rather than equity to
finance their investment in a subsidiary.
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To What Extent Do Capital Structures
Vary Across Different Countries?
• Early studies suggested that average capital
structures varied widely among the large
industrial countries.
• However, a recent study, which controlled for
differences in accounting practices, suggests
that capital structures are more similar across
different countries than previously thought.
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Median Capital Structures
(Measured in Terms of Book Value)
Country
Raw
TL/TA
Raw
D/TA
Adjusted
TL/TA
Adjusted
D/TA
TIE
Canada
56%
32%
48%
32%
1.55X
France
71
25
69
18
2.64
Germany
73
16
50
11
3.20
Italy
70
27
68
21
1.81
Japan
69
35
62
21
2.46
U.K.
54
18
47
10
4.79
U.S.
58
27
52
25
2.41
Mean
64%
26%
57%
20%
2.69X
Std. Dev.
8%
7%
10%
8%
1.07X
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Multinational Working Capital
Management
MULTINATIONAL CASH MANAGEMENT
• MNCs use the same procedures as domestic firms
to achieve similar cash management goals.
• Distances are greater with delays.
• Access to more markets for loans and for
temporary investments
• Cash is often denominated in different
currencies.
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22-57
Multinational Credit Management
• Credit is more important, as firms in lesserdeveloped countries often rely on credit.
• Letter of credit (LC) and banker’s acceptance (BA)
are common methods of payment in
international trade.
• Many companies buy export credit risk insurance
(Canada’s Export Development Corporation
(EDC)) when granting credit to foreign customers.
• Credit for future payment may also be subject to
exchange rate risk.
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22-58
Multinational Inventory
Management
• Inventory decisions can be more complex,
especially when inventory can be stored in
locations in different countries.
• Some factors to consider are shipping times,
carrying costs, taxes, import duties, and
exchange rates.
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